concept of materiality in federal securities regulation: From TSC Industries to SEC regulation fair disclosure, The

Attorney-CPA, The, 2001 by Carroll, Brian

The US. Securities & Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author, and do not necessarily reflect the views of the Commission or the author's colleagues upon the staff of the Commission.

The concept of materiality is central to our system of federal securities regulation. Its appears throughout federal securities statutes as a threshold element for defining fraudulent conduct, see e.g. Securities and Exchange Commission 's ("SEC") Rule 10b-5, 17 CFR Section 240.10b-5 (1987), issued pursuant to Securities Exchange Act of 1934 ("Exchange Act") Section 10(b), 15 U.S.C. Section 78j(b); and SEC Rule 14a-9, 17 CFR Section 240.14a-9 (1975), issued pursuant to Exchange Act Section 14(a), 15 U.S.C. Section 78n(a). When a materiality requirement does not explicitly appear in a statute, it is sometimes viewed as an implied, common law requirement, see e.g. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) (interpreting Investment Advisers Act of 1940 Section 206). While judicial opinions seek to interpret its bounds under the law, accounting literature similarly strives to define it's meaning when applied to financial statement preparation, see e.g. SEC Staff Accounting Bulletin 99 - Materiality, 17 CFR Part 211 (August 12, 1999).

This article briefly analyzes the judicial treatment of materiality as a legal concept under federal securities laws, the SEC's staff's view of materiality as an accounting concept and the current issues raised by its application under the SEC's Selective Disclosure and Insider Trading regulation ("Regulation Fair Disclosure"), 17 CFR Parts 240, 243 and 249 (August 24, 2000).

In TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 96 S.Ct. 2126, 48 L.Ed. 2d 757 (1976), the Supreme Court articulated a legal standard for materiality. The Court was faced with an issue of whether a proxy statement violated SEC Rule 14a-9 because it omitted material facts that were necessary in order to make the statement not false or misleading. (SEC Rule 10b-5 contains a similarly worded provision.) The Court held that the materiality element of Rule 14a-9 is met if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available." 426 U.S. at 449. Later, in Basic Incorporated v. Levinson, 485 U.S. 224. 108 S.Ct. 978, 99 L.Ed. 2d. 194 (1988), the Court adopted the TSC Industries standard of materiality for SEC Rule 10b-5, issued pursuant to Section 10(b) of the Exchange Act.

SEC Staff Accounting Bulletin 99 - Materiality ("SAB 99") states that the FASB's Financial Accounting Concepts No. 2 defines materiality as follows:

The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.

This definition is juxtaposed against the Court's TSC Industries standard and viewed by the staff as "in substance identical to the formulation used by the courts." SAB 99 at p. 3; see also Audit Risk and Materiality in Conducting an Audit, AU Section 312.

Moreover, the SEC's staff points out that both the it surrounding circumstances" language of Financial Accounting Concepts No. 2 and "total mix" of information language of TSC Industries require materiality to be assessed in an appropriate context. SAB 99 at p. 3. While the "total mix" judicial concept is applied to quantitative measurements of materiality in the form of numerical or percentage measurements of misstatements, the staff goes on to explain that qualitative factors in determining materiality are also appropriate under this standard.

Hence, when considering-the "total mix' of information, a "quantitative" misstatement below a numerical threshold, i.e. 5% of net income, may, because of "qualitative" factors, cause such a misstatement to be material. SAB 99 at p. 4. SAB 99 lists considerations that may "well render material a quantitatively small misstatement of a financial statement item." Id. These considerations include whether the misstatement masks a change in earnings or other trends; affects the registrant's compliance with regulatory or loan covenant requirements; hides a failure to meet analysts' consensus expectations; conceals an unlawful transaction; or, under certain circumstances, may result in a significant negative or positive market reaction. SAB 99 at pp. 4 & 5.

Effective October 23, 2000, the SEC's Regulation Fair Disclosure entered this mosaic of materiality standards. In part, Regulation Fair Disclosure generally limits an issuer's disclosure of material, nonpublic information to certain financial professionals (i.e. securities analysts) by prohibiting selective disclosure. (For an excellent discussion of the regulation and its operation, read Daniel L. Goelzer's article entitled "SEC Adopts Regulation FD Prohibiting Selective Disclosure of Material Information," Vol. XXXVI, No. 4 The Attomey-CPA 4 (2000)). Although Regulation Fair Disclosure did not define the term "material," the SEC release adopting the regulation referenced the existing body of authority by citing the judicial standard of materiality as represented in TSC Industries and Basic, and the accounting concepts as stated in SAB 99. Regulation Fair Disclosure Adopting Release at p. 10 ftnts. 38 & 39.